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Seeing the Forest through the Debt

Forest Oil (FST) hails from the lineage of noble companies who attempted to increase shareholder value by using financial leverage to increase natural gas reserves during the bull gas market that was 2005 to 2008. Unfortunately for this lineage, the prolonged period of low natural gas prices that ensured has companies like itself, along with Chesapeake Energy (CHK), Quicksilver Resources (KWK) and GMX Resources (GMXR), et al selling off assets to finance debt like they’re Nicholas Cage. As an analyst and investor, these are the stories I find exciting because of their potential as a value stock. I’m not looking for the best run company with the best assets, I’m looking for the best run company with the best assets at the best price. With that said, screw a sexy company like EOG Resources (EOG), let’s delve into the world that is *cough* Forest Oil.

My research for this piece began with FST’s third quarter 2012 earnings call, which was held on Tuesday October 30, 2012. I don’t think I’ve listened to a more melancholy earnings call during my admittedly brief analyst career. Debt aside, at least on paper, I think there’s a lot to be excited about with this story. The company has 40k net of solid Eagle Ford acreage, 109k net in the Texas Panhandle where it has drilled eight monster Hogshooter wells and an East Texas gas asset that provides its portfolio with plenty of natural gas upside. I do understand Forest’s attitude, a debt-to-market cap of nearly 200% will keep even the most optimistic financial teams up at night. So, what are they doing to manage their debt levels?

If you aren’t familiar with Forest’s debt levels, it had total debt of $2.1 billion as of September 30, 2012. The company is taking a common sense approach to lowering its debt, the first step of which was to refinance half of the six-hundred million it owes in 2014 by issuing lower rate notes which will mature in 2020. This frees up some near-term liquidity for FST, whose next principal payment isn’t due until 2019 (the company is on the hook for $1.5 billion during 2019 and 2020). FST will also net approximately $270 million from non-core asset sales which it expects to close on in November and use to lower its debt. After the refinancing and asset sales, the company will have approximately $1.8 billion in debt outstanding which translates to a debt-to-market cap of 190%.

The remaining $300 million the company will pay in principal in 2014 should be covered through the divestiture of its 114,500 net acres in the Delaware and Midland Basins of West Texas/SE New Mexico. As shown by the table below, the average acreage value for assets in this area is $4,316 which values FST’s acreage at $494 million. Even if FST receives a valuation near the lower bound of the sample size, it will still cover its expected principal payments in 2014. It’s my view that this company should be soluble through the end of fiscal year 2018, but surviving beyond that will require the type of fiscal austerity that would impress even the Greeks.

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Forest seems to have finally figured out that it doesn’t have daddy’s credit card anymore and needs to start showing some financial constraint. Its Q4’12 capital budget is approximately $84 million, down 50% from Q3. For fiscal year 2012, spending will be an estimated $624 million, $59 million less than in 2011. Next year, spending figures to decrease significantly as the company attempts to spend within cash flow. It only generated $286 million in cash flow during the nine months ended September 30, 2012 and if cash flow is flat year-over-year (conservatively speaking), the company will have $381 million to spend next year. While that's not the type of spending trajectory we want to see for a potential investment, at least Forest is taking its medicine.

The company's survival beyond 2018 will be dependent upon its ability to develop its existing asset base while spending within cash-flow. On paper, it has a great asset in the Eagle Ford with 40k net in Gonzales County, but its results there have been disappointing to date. Based on the data I saw from the Texas Railroad Commission, the company has one good well in Holmes 1H which has produced more than 100k barrels of oil in just under a year, a handful of economic wells and just as many poor wells. It's not unusual for a company to have inconsistent results at the beginning of a drilling program, but I would have liked to see a few more good wells from its Eagle Ford program. I still think this acreage will turn out to be productive for the company, but FST's struggles there to date are something to monitor.

The company has had much more success in the mid-continent, where according to its Q3'12 earnings call it has recovered nearly one million barrels of oil equivalent (~70% oil) from eight hogshooter wells during the past year. This acreage is the company's prized asset, but it's going to need its Eagle Ford acreage to be economic for it to survive.

The company's reserves are currently trading at an EV/Mcfe of $1.46, which is quite a bargain considering its assets. However, I'm not sold on its ability to develop its existing assets at this point and to be honest I don't need to be as this company's stock doesn't look to be moving up anytime soon. Also, management seems to be comfortable with maintaining a debt level circa $1.5 billion, which would still put its debt-to-cap North of 150%, a little too high for me. I'm not touching Forest, but if the debt doesn't bother you it might be a stock to keep an eye on down the road.